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Building a Risk Measurement Framework for Hedge Funds and Funds of Funds

University of Cambridge, Judge Institute of Management Working Paper No. 08/2004

17 Pages Posted: 21 Feb 2005  

Toby R.J. Goodworth

IO Investors

Chris Jones

University of Cambridge - Judge Business School; Io Investors

Date Written: 2004

Abstract

In the first of two papers, we present a factor-decomposition based framework that facilitates non-parametric risk analysis for complex hedge fund portfolios in the absence of portfolio level transparency. Our approach has been designed specifically for use within the hedge funds-offunds environment, but is equally relevant to those who seek to construct risk managed portfolios of hedge funds under less than perfect underlying portfolio transparency. Using dynamic multivariate regression analysis coupled with a top-down qualitative understanding of hedge fund return drivers, we are able to perform a robust factor decomposition to attribute risk within any hedge fund portfolio with an identifiable strategy. Furthermore, through use of Bayesian-adjusted correlated Monte Carlo simulation techniques, these factors can be employed to generate implied risk profiles at either the constituent fund or aggregate funds-of-funds level. As well as being pertinent to risk forecasting and monitoring, such methods also have application to style analysis, profit attribution, portfolio stress testing and diversification studies. In this first paper we present the technical foundations of such a framework. The follow-up paper (Part II) will present detailed application of the concepts discussed in Part I to a broad base of hedge fund strategies and funds-of-funds.

Keywords: hedge funds, risk analysis, funds-of-funds

JEL Classification: F47, C11, C15

Suggested Citation

Goodworth, Toby R.J. and Jones, Chris, Building a Risk Measurement Framework for Hedge Funds and Funds of Funds (2004). University of Cambridge, Judge Institute of Management Working Paper No. 08/2004. Available at SSRN: https://ssrn.com/abstract=670089 or http://dx.doi.org/10.2139/ssrn.670089

Toby R.J. Goodworth (Contact Author)

IO Investors ( email )

126 Jermyn Street
London SW1Y 4UJ
United Kingdom

Chris Jones

University of Cambridge - Judge Business School ( email )

Trumpington Street
Cambridge, CB2 1AG
United Kingdom
+44 (0) 1223 339651 (Phone)
+44 (0) 1223 339701 (Fax)

Io Investors ( email )

126 Jermyn Street
London SW1Y 4UJ
United Kingdom

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